Explaining FinReg: Fannie and Freddie

The right way to think about Fannie Mae and Freddie Mac is to think about the widespread availability -- at least before the crisis -- of 30-year, fixed-rate mortgages with no prepayment penalty. That is not a financial product that flourishes in the state of nature, and for obvious reasons. If you're a bank, why do you want those mortgages? If interest rates go down, people refinance and pay the loan back early. If they go up, you might be losing money on the loan. It's heads they win, tails you lose.

If you've got one of those mortgages, though, you might have Fannie Mae and Freddie Mac to thank. The mortgage giants, slightly confusingly, do not sell mortgages. They buy them from the banks that sell them. About 90 percent of them, to be precise. They do that to make mortgages -- and thus home ownership -- cheaper. That's fine. If the country wants to encourage home ownership as a policy, subsidizing banks so they can offer better mortgage terms is a sensible way to do it.

The problem is that Fannie and Freddie are not a direct and simple subsidy for the banks. They are private companies with a government charter. Rather than using taxpayer dollars to subsidize mortgages, they were borrowing money very cheaply because their quasi-governmental status assured the market that there'd be a taxpayer bailout in the case of any sort of collapse. That is to say, their business model relied on markets ignoring the risk of their activities. And then, because they were private companies with shareholders to please, they also got into slicing and dicing mortgage packages to make money like an investment bank rather than a housing policy. In theory this should've worried the markets where they borrowed their money, but again, the government backstop saved them. Forget too-big-to-fail. This was not-allowed-to-fail.

So, of course, they failed. As Raj Date of the Cambridge Winter Center put it to me, "anytime the debt markets aren't paying attention to your risk profile, you're doomed."

Their failure was not, as some would have it, the cause of the mortgage crisis, or even close. For one thing, only about 2 percent of their portfolio was subprime. For another, they didn't start backstopping the subprime market till long after it had taken off. And for a third, their greatest losses actually were in non-subprime loans.

But they were part of the problem. And the fundamental mismatch between their risk and activities will continue to cause problems. But solving the Fannie and Freddie problem is more complicated than it might appear. What you're talking about, essentially, is a massive subsidy for home ownership. That is to say, a massive subsidy for the middle class. So easy as it is to talk about the failure of Fannie and Freddie, it's a lot harder to talk about their elimination, as that's talking about the removal of a popular subsidy in a fragile market.

Which explains why the Republican financial-regulation proposal handled the Fannie and Freddie problem by directing the president "to submit a plan to reform [Fannie and Freddie] to Congress no later than six months after the enactment of the Act." Republicans don't normally solve problems by asking President Obama to solve them, but no one wants their fingerprints on this one.

Of course, you don't necessarily need to eliminate Fannie and Freddie. You could solve the problem by fully incorporating them into the government and making them a straightforward housing subsidy rather than a stealth housing subsidy hidden within a profit-maximizing company. But it's not clear that bringing more major institutions under the control of the government is going to be popular, either. So what do you do?

Well, it's hard to say. Procedurally, Democrats think that the Fannie and Freddie question is a housing market question and should be dealt with in the context of a major housing-policy bill. What that bill will do, however, is anyone's guess. And that's pretty much where we are on Fannie and Freddie.

I don't see why it's a bad deal for the banks. Sure, you pay back the 30-year mortgage early: The bank gets 100% of their money back and got (to make up some numbers) 6% interest for 10 years when the going rate was 4% on a 10-year loan.

Meanwhile, because many people sell their homes for a variety of reasons, they are not going to go with a product that penalizes them for moving to take another job. Good luck selling mortgages that say you cannot sell your house for 30 years.

Umm, as long as you can reasonably value the embedded put option and hedge (or price) some of the interest rate risk, this statement isn't really true. much of fannie and freddie had to with credit risk (or the relectuance to allow for market credit pricing) and capital capacity, not the interest rate risk or embedded puts of 30 year fixed.

well let me modify my response above: the gse's make it so you don't (on purpose) have to price the pre-payment risk (via redemption fees or just upfront as an option). but this doesn't mean that the absence of gse involvement makes such loans necessarily losing propositions IMO

30 year fixed rate mortgages with no pre-payment penalties were the coin of the realm for home buyers through the 40s, 50s, 60s, and 70s. They were the ultimate goal of buyers using adjustable rate instruments in later decades.
With decent underwriting and PMI, they were great investments for lenders - about as safe as government bonds with higher returns.
What in the world are you talking about?????

The only thing wrong with Fannie and Ginnie Mae was the criteria for who to loan to, just as it was what was wrong with the entire country, in the grip of the fad for deregulation.

As an investor, my family found them wonderful, a Ginnie Mae could basically be like a 30-year treasury bond, at the same rate, but would pay themselves off within a year or two as enough homeowners paid off early. So if you wanted a 30 year T-Bill rate but didn't want to lock anything in for years, it was perfect. You could sell any time in fact, you just had to watch what the market was doing and what the (coupon) price was when doing so.

Basically the only thing that needs fixing is more stringent loan requirements, but that's true everywhere now and well underway.

Of course, the conservative media won't ever hear the "2%" figure you quoted, to them this was all a failure of government, thus any government-related agency must be the cause of it all, rather than private banks as was actually the case.

Yeah, I don't understand why 30-year, fixed-rate mortgages with no pre-pay penalty would not be acceptable to a bank without government backing. As long as loans are offered to borrowers with acceptable levels of risk, which I gather should really be true for most lending, it seems like most mortgages will be paid back early when people sell their houses. The bank gets the early years of the mortgage, which are almost all interest, and then gets the rest of their money back. What they're skipping over is the later years of the mortgage, where most of the payments are principle, and therefore less pure profit.

Sure, they'd make more money if the interest rate could float or if the borrower was locked into 30-year mortgages, but this just means they don't make quite as much as they originally thought at the start of the mortgage. Of course, they have fewer years of risk too.

In addition to your fundamental supposition about prepayment and interest rate variability being wrong, you are wrong in other places.

"Their failure was not, as some would have it, the cause of the mortgage crisis, or even close. For one thing, only about 2 percent of their portfolio was subprime."

First, the 2% figure is simply wrong- just look at the Alt-A numbers. I know you're a gray area opinion piece writer, but that can be fact checked. Second, subprime was not the cause of the mortgage crisis, it was the "unprecedented" price decline that caused the mark-to-market problems in the value of the debt.

When housing prices decline 40%, the loan amount is greater than the present value of the underlying asset, even if it was 20% down payment. That is the fundamental problem, when combined with the increased default rate, where there were more losses to defaults in the non alt-a category than in alt-a, mark to market was forced.

I think we can all agree that mortgage securitization has been mishandled. Installing more regulated facility for those transactions (with higher down payment requirements and new models of price variability) so that they can be more safely traded would be a start. Stopping the GSEs at least from buying low down payment loans tomorrow would also be good.

Why is it no one is talking about how mortgage payments are amortized? Lets say a person makes $2500/monthly payments on a $500,000 purchase. Over a 5 year period those payments add up to $150,000. Maybe 5% or $7,500 of this went to principal on the loan. The bank actually pockets $142,500 in interest over this 5 year period. Looks fairly profitable to me.

What we really need to do is to force these GSE's to get back to the more conservative underwriting principles we saw in the early '90s refinance boom. Congress pushed them to make loans "streamlined" and "more affordable," which is another way of saying "loaning more money to those who are increasingly unlikely to pay it back."

HUD, VA, Fannie, and Freddie all should go back to requiring hard and fast financial statements over verbals, have a care for both the front and back end debt-to-income ratios, and at least require nominal down payments from the highest-risk borrowers as good faith.

Yes, this will make it more difficult to buy a house. But with so much on the line, it should be at least a little difficult. And in the long run, it will make it easier for those who have houses to keep them.